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Valuation Challenge: 'Auction rate action plan'

Cindy Ma, managing director of Houlihan Lokey, discuses how to analyse investment of cash resources in auction-rate securities.

THE CHALLENGE:
During the due diligence process, a potential portfolio company discloses substantial investment of its cash resources in various types of auction-rate securities (ARS):

  • 1. CDOs of asset-backed securities (ABS CDOs)
  • 2. Monoline contingent-capital facilities
  • 3. Student loan auction-rate securities (SLARS)
  • 4. Municipal auction-rate securities (MARS)

    What types of analyses should be performed on these securities to establish a level of comfort around the value of the company's ARS holdings?

    CINDY MA's ANSWER:
    Two distinct and critical issues needed to be addressed in initial phase of analysis:

  • 1. What is the likely credit impairment on this security?

    2. What is the market's perceived level of risk in this security?

    Different types of ARS can be divided into credit-impaired and credit-worthy groups. ABS CDOs and monoline contingent-capital facilities were among the first types of ARS to experience failed auction, and for good reason: they have significant exposure to subprime mortgages and related securities. These types of ARS have been valued at severely distressed levels, and analyzing such securities generally requires detailed credit analysis of the entity issuing the paper as well as the collateral backing them.

    Many other types of ARS, however, are generally credit-worthy. In valuing credit-worthy securities, we must first decide on the valuation model: should we use a market-based approach or a fundamental cash flow-based approach? Despite the existence of secondary markets for these securities, we do not view them as “active markets” as they tend to have very low trading volume and participants are often forced into liquidating their holdings. We therefore view a discounted cash flow approach as the most appropriate valuation methodology in the current illiquid market environment.

    As in any fixed-income valuation, two main assumptions form the basis of this methodology: the expected cash flows from the ARS and the appropriate risk-adjusted discount rate used to compute the present value of those cash flows. Certain considerations are especially important for valuations of ARS:

  • Is there a possibility of prepayments of principal? Certain SLARS are structured with this possibility.
  • Could the issuer redeem or refinance the issue? MARS have been more active than SLARS in this regard, but many market participants have been directing significant attention to this problem in both markets, and refinancing solutions could be implemented for SLARS as well as MARS. If this possibility is considered, what is the timeframe?
  • Could the banks that formerly supported the auctions step in again? Based on recent news of settlements, these banks may have an incentive to help the auction markets function again.

    Other factors that could influence redemption activity include the issuers' ability to raise new capital; structural features of the ARS such as parity, seniority, and collateral quality; and the availability of appropriate refinancing vehicles such as variable rate demand obligations in different markets.

    The other main assumption involves the appropriate discount rate used to compute the present value of cash flows. With no active market for comparable securities, the benchmark used to approximate the risk of the ARS must be taken from the closest possible active markets.

    Suggestions include:

  • Indices of similar securities, such as those published by SIFMA
  • New-issue spreads on similar structures
  • Spreads published by research analysts

    Since these indications are often taken from much more liquid markets, it is often appropriate to apply an illiquidity discount in the form of an additional spread applied to the discount rate. Many publications have attempted to estimate this illiquidity discount in fixed-income markets; whether you use the spread between on-the-run and off-the-run Treasuries or the spread between short-term CD rates and Treasuries, this spread should be added to the benchmark discount rate to derive the appropriate risk-adjusted discount rate for ARS.